A Savage Lesson From Europe for Muni Bonds

The consensus of the experts in municipal debt is that cities and states will make “the hard choices”—namely budget cuts, reductions in pension and health benefits, and tax cuts—to avoid defaulting on their bond obligations.

This is the only rational choice, many of those who watch the market closely insist. Requiring bondholders to take losses would cut of “market access” and make future borrowing more expensive—if not impossible.

But recent events in Europe should challenge these views. The measures supported by the European Central Bank to stave off a debt crisis in Greece and Portugal or a banking crisis in Ireland largely mirrored those that muni-bondholders expect of cities.

The rescue program in Europe consisted of emergency loans in exchange for whatPaul Krugman describes as “savage austerity programs, mainly consisting of huge spending cuts.”

It didn’t work. Savage Austerity prolonged the European economic and financial crisis—perhaps even broadening and deepening its effects. The promised improvement in market confidence and economic expansion didn’t materialize.

The main objections to these measures have now been proven correct.

They imposed almost unbearable budgetary pain, and lowered government revenues by worsening the economic slump. So now the Austerity Savages are back at the negotiating tables, trying desperately to avoid the only real options available: redistributing wealth from the better off Europeans to the worse off, or giving bondholders a haircut.

Will Savage Austerity work better for municipal bonds? There may be some cases—such as New Jersey and Wisconsin—where spending was so wasteful and economic opportunity so plentiful, that it can work—at least when modified to include tax cuts.

But on a broader scale, it seems unlikely that the states and cities will be able to avoid the fate of Europe. “Cutting” state and local spending is mostly about laying off people with government jobs. This will increase unemployment—without producing the positive economic balancing effects that require tax cuts. This will deepen the economic slump, at once reducing government revenues and increasing the reliance on government programs.

Workers who have seen their savings evaporated by the housing slump and stock market volatility are unlikely to accept a reduction in pension and health care benefits. If the Obama administrations’ healthcare programs do not succeed in reducing health care costs—and no one really thinks they will—our elderly will require more spending, not less.

With the Austerity Savages of muni bonds win out? Perhaps at first, just as they did in Europe. But the budgetary gap between promises made (to workers, to bondholders, to working people with families that need educating) and the ability to pay in many areas is likely to be eye-poppingly wide. And the wider the gap, the more savage the austerity.

Eventually, at least some of our cities and states may decide that the “hard decision” is not worth making. That “market access” is not worth the price of a localized Great Depression and a betrayal of promises made to teachers, firefighters and police officers. Bondholders may find that themselves around the table, talking about “restructuring”—just as they have in Europe.